July 16 (Bloomberg) -- For evidence that U.S. bond
investors aren’t being satisfied by Federal Reserve Chair Janet
Yellen’s dovish words, take a look at government-backed mortgage
securities.

In a market dominated by 30-year loans, buyers from banks
to real estate investment trusts have piled into debt tied to
15-year mortgages offering greater protection against rising
interest rates. More demand for the shorter-term debt caused
yields in the securities to evaporate, with one measure of
spreads over Treasuries narrowing to just 0.02 percentage point
last month from more than 0.4 about a year ago.

While bond bears were pushed to capitulate across fixed-income markets as yields defied forecasts and declined this
year, some investors are still looking for safety. For those
willing to sacrifice returns, 15-year securities offer banks and
REITs in the $5.4 trillion mortgage-bond market a way to hedge
some of their risks while sticking with the debt, according to
Brean Capital LLC’s Scott Buchta.

“It’s one of those things where these guys are investing
defensively,” said Buchta, the head of fixed-income strategy at
the New York-based brokerage. “You’re not trying to kill it,
you’re trying not to be killed if things go the other way.”

Dovish Fed

Yellen reiterated to lawmakers yesterday that “a high
degree of monetary policy accommodation remains appropriate” to
combat persistent weakness in the nation’s economy. The central
bank’s target for short-term rates -- held at almost zero since
December 2008 -- is likely to stay low for a “considerable
period” after the Fed ends its unprecedented bond purchases as
soon as October. The U.S. Treasury 10-year yield rose 0.01
percentage point to 2.56 percent at 8:52 a.m. in New York,
according to Bloomberg Bond Trader data.

Shorter maturities on 15-year mortgage bonds and faster
repayment of principal than 30-year debt mean they’ll slump less
if long-term yields climb. There’s also less risk that the notes
remain outstanding longer than investors anticipate if higher
borrowing costs curb refinancings and home sales.

Even as bond managers have taken on more risk as 2014
progressed, they’re still looking to shield against rising
yields that can lead to losses on fixed-income securities.

In January, the duration of their holdings, a measure of
risk that is partly tied to the length of maturities, fell the
most below their stated targets in years, according to surveys
by Stone & McCarthy Research Associates. While not as bearish,
fund managers were still positioned below their targets in the
Princeton, New Jersey-based research firm’s July 8 poll.

Cushioning Blows

While 15-year mortgage securities look too expensive to
most investors, the rate protection is more important to certain
types of buyers, said Jason Callan, Columbia Management
Investment Advisers LLC’s structured-products head.

“There’s been significant demand from the REITs, so it
makes sense why valuations are where they are,” said Callan,
who oversees about $17 billion in mortgage-related assets from
Minneapolis.

Banks are being lured to the shorter debt in part because
tougher capital rules have left them with even more incentive to
avoid paper losses on bond holdings, Buchta said. With
increasing deposits and limited loan growth, commercial banks
still boosted their agency mortgage-bond holdings by about $35
billion in the first half of this year to $1.35 trillion, Fed
data show.

REIT Demand

REITs that invest in mortgages shifted more into safer 15-year debt after their shares were rocked last year by the debt
slump that followed the Fed’s signals it was approaching the
start of a tapering of its then-$85 billion in monthly bond
buying. They lost 20.7 percent in the four months ended August
2013, assuming reinvested dividends, a Bloomberg index shows.
They’ve since gained almost 22 percent as bond appreciated.

At American Capital Agency Corp., the second-largest
mortgage REIT, 15-year securities jumped to 48 percent, or $34
billion, of its investments as of March 31, according to company
presentations. That’s up from 22 percent, or $22.6 billion, a
year earlier.

The increase mainly occurred in the second quarter of last
year, with the Bethesda, Maryland-based firm reducing the
holdings this year, President Gary Kain said in an e-mail.
“Many people seem to attribute the strength of 15s to us
despite the fact we were net sellers,” he wrote, saying he
couldn’t comment further before his company’s quarterly
earnings.

Risk Trade-Off

Kain said during a presentation last month that he still
believed yields will rise and spreads will widen over time. The
shorter securities offer good protection against that with
principal that comes back more quickly, he said.

The safety is coming with a cost. Thirty-year mortgage
securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae
have gained 3.9 percent this year after losing 1.6 percent on
average last year, according to Bank of America Merrill Lynch
index data. Fifteen-year debt, which fell just 0.92 percent in
2013, has underperformed this year with a 2.5 percent gain.

For 30-year securities, a measure of relative yields known
as option-adjusted spreads, which takes into account expected
rate volatility, narrowed to 0.29 percentage point, from 0.6
percentage point a year ago, the data show. Fifteen-year bond
spreads fell to 0.02 percentage point on June 23 before widening
to 0.11 percentage point.

‘Extreme Side’

Not all mortgage REITs piled into 15-year securities. The
debt accounted for just 11.4 percent of Annaly Capital
Management Inc.’s $65.3 billion in fixed-rate agency mortgage
holdings on March 31, according to a company presentation.

“The valuations are on the extreme side,” David
Finkelstein, head of agency mortgage trading at New York-based
Annaly, the largest mortgage REIT, said last month in a
telephone interview.

Fifteen-year mortgages have become rarer because they are
typically used more during periods of high refinancing, as
borrowers seek to shorten or maintain the length of their debt.

As higher rates reduced refinancing, issuance of 15-year
Fannie Mae and Freddie Mac bonds fell 69 percent to $43.5
billion in the first half of 2014 from a year earlier, compared
with a 56 percent drop to $183.6 billion for 30-year securities,
according to Bank of America data. The amount of conventional
15-year debt outstanding dropped $15.5 billion, while the 30-year market grew $12.3 billion.

Shrinking Market

The shrinking of the 15-year market will help to support
the debt, Satish Mansukhani, an analyst at the bank, has written
in reports this year. Nomura Holdings Inc. analysts led by
Ohmsatya Ravi recommended bets this month that 30-year debt
would outperform 15-year securities.

Banks and other investors, which have also turned to slices
of debt known as collateralized mortgage obligations for
protection, should start favoring rarer and higher-yielding 20-year securities over 15-year bonds, said Walt Schmidt, a
Chicago-based strategist at FTN Financial.

“We’re more in the camp that things aren’t going to move
so soon,” he said in a telephone interview. For those concerned
that long-term rates are set to spike, “the 15-year market is
probably a good place to be.”

(An earlier version of this story corrected the spelling of
Mansukhani’s name in the 22nd paragraph.)